Traders facing up to nothingness

The central theme of financial markets at the moment is a profound state of nothingness.

This environment of “eerie calm" is challenging the most famed money managers. The toughest trading conditions he’s seen in his career is how Paul Tudor Jones described the backdrop. He’s calling for “a macro doctor to prescribe central bank Viagra" to end his “manic-depression in a volatility-compressed world".

Macro-hedge funds, such as Tudor Jones, which shift billions of dollars around in the most liquid assets trying to predict the major market moves, are having one of their worst years, largely because markets simply aren’t moving around at all.

In a grand sense, nothing is happening. The market’s measure of volatility, the VIX index, is testament to just how calm the waters are. On Wednesday, the VIX traded at 12.16, just a whisker away from its lowest level since the financial crisis.

Even measures of volatility of choppy currencies like the Australian dollar are their lowest since November 2013, while the euro’s is the calmest since its inception. Bonds have hardly budged all year. The 10-year US bond rate has stayed between the 2.5 per cent and 3 per cent guardrails, despite signs the US economy is edging closer to recovery.

In coming to terms with a market where measures of risk are falling to historic lows, traders are divided. Do they position for a violent end to this period of calm or do they to take even more risk in the hope that the benign environment persists for many months to come?

The “fundamentals" might suggest a correction is imminent. But this is absolutely not the environment to invest based on fundamentals.

Citi credit strategist Matt King has shown that corporate debt spreads are declining even as corporations are increasing their debt. +Some estimate US corporate leverage increased by a third just in the last year, but spreads have ground ever tighter. The extent of issuance in the bond market CCC-rated companies, those on the brink of default, is the highest its been since 2007 – a sign of just how much risk investors are willing to take for such little reward.

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Even in Australia, Qantas, a company that only in February was pleading to the government for a funding backstop, became the first company in recent years to issue junk bonds in the local wholesale market – raising eight-year debt. US equity prices have moved higher in recent months even as companies have revised their earnings downward. It sounds like madness, but there are experienced investors who feel the smart thing to do is to carry on, and continue to take risk. There may be some structural forces at play.

The risk-on camp’s main argument is that we have entered a slow-growth low-inflation world were interest rates will stay low, rewarding investors that reach for yield. They don’t see an imminent end.

The risk-off camp see an unsustainable ramping-up in risk that will end sooner rather than later. They have identified three catalysts that will shake the markets before year’s end.

One is that the US Federal Reserve may have committed a policy error and will be forced to play catch-up on raising interest rates, catching investors by surprise. Another is the rising tensions over the Ukraine. Hedge fund manager Chris Shumway says the risk of impact on the financial markets is mispriced and investors should be hedging. Finally, China’s slowing economy and large build-up in credit is an identifiable source of a painful correction in assets.

So far markets have acknowledged, but brushed off, all three. For the time being the winning trade remains a bet on nothing happening.